Friday, May 18, 2012

The Dangers of High-Speed Trading - US  Business News - CNBC

Arbitrage potential at the speed of light at 11 millisecond between NYSE and CME...

Comstock | Getty Images

Eric Scott Hunsader has gone completely down the rabbit hole, and he doesn’t like what he’s finding there.

Hunsader is the CEO of a Chicago-based market analytics firm that specializes in high-frequency trading — super fast trades executed at the speed of light that can alter asset prices faster than human beings can react to the changes.

Based on his own analysis, Hunsader has come to a startling conclusion: Markets today are even more susceptible to sudden failure than they were two years ago during the “flash crash,” which brought the stock market down by about 1,000 points in mere minutes.

That’s because a new breed of trader armed with hundreds of millions of dollars to deploy is trading so fast—and with such spikes in volume—that he can dry up liquidity in an instant, causing severe price swings.

To explain to a lay person, Hunsader offers up two examples of the kinds of trades he’s seeing. The first happened less than a minute before the April Jobs report was released by the Department of Labor in Washington.

That report is traditionally one of the most dramatic market-moving events of each month. As a result, traders tend to lie low in the minute or so before the number comes out at 8:30 a.m. on the first Friday of each month, so they don’t get caught when the market changes.

But Hunsader argues that he’s seeing a small group of high speed traders who aren’t lying low. In fact, they’re taking advantage of the regular and predictable lull in the market to pop high speed trades in order to intentionally create a several hundred millisecond burst of volatility, and then execute follow-on trades to profit from that.

To understand what happens, you have to go inside just one second of trading and look at the way markets move at speeds that can be almost imperceptible to human beings.

On May 4, Hunsader says, he spotted those traders just before the April number was released. At 8:29:20 and about 200 milliseconds, he says, someone — he has no way of knowing who — executed a trade in the five year T-note futures market worth about $150 million.

A chart of that single second in the market shows that prices are relatively stable until the trade. And just after that, for the rest of the second, prices spike, and gyrate up and down as other automated high speed computers react to the trade.

Hunsader says he doesn’t know exactly how the traders make money off the volatility that they create, but he suspects they’re making other trades in the milliseconds following their market moving trade that take advantage of the relationships between this market and others that are impacted by it.

The traders that move first, and fastest, win, he says.

“It’s like two guys running in the woods, and they see a bear and one guy drops down and puts his shoes on and the other guy says, ‘what are you doing that for, you can’t outrun a bear,’” Hunsader says. “And the guy goes, ‘I don’t have to outrun the bear, I just have to outrun you.’”

On another occasion, Hunsader says he saw traders taking advantage of something as fundamental as the speed of light.

Because trades are executed by fiber-optic cable, the fastest they can travel—and the fastest anything in the universe can travel—is the speed of light. But even at that speed, it takes about 11 milliseconds for information from exchanges based in New York to get to exchanges based in Chicago. And that provides an opportunity for arbitrage for those who can move fast enough.

“Recently, they put in this new high speed line between Chicago and New York,” Hunsader says. “Essentially (they) drilled through mountains to shave a few milliseconds — thousandths of seconds — off, getting it down to 11 milliseconds. But I think somebody’s figured out how to get it to zero milliseconds.”

And the way they do that, in effect, became clear on May 3, Hunsader argues.

At 9:59:11 and about 620 milliseconds, someone executed a trade in Chicago, purchasing about 1,300 ES contracts for about $70 million. That happened to come in a lull just before two economic indicators were to be released at 10 a.m. that day.

At the exact same millisecond, 9:59:11 and about 620 milliseconds, Hunsader says, another trade was executed: Somebody bought 260,000 shares of a closely correlated product, SPY, for about $36 million.

Hunsader has no way of knowing for sure it was the same person executing both trades. But he says he sees same millisecond trades happening in both cities in related products often enough that he doesn’t think it can be pure coincidence.

In fact, he says, someone placing big orders in related products in both cities would gain a valuable advantage: for 11 milliseconds, they would be the only ones in the world who knew what happened in both markets.

By the time Chicago received the information about what happened in New York, and New York received the information about what happened in Chicago, Hunsader says, the traders who execute such trades would have a relatively long time to position themselves for the predictable fallout. And that’s a profit opportunity.

“The speed of light is fast,” Hunsader says, “But it’s not as fast as the high frequency traders would like it to be.”

The trick is, you have to have a super-fast computer and $100 million in deployable cash to make it work.

Hunsader says he sees these trades happening so frequently, in fact, that he advises individual investors not to make any trades at all between 9:58 and 10:02 a.m. Eastern, since many economic reports are released at exactly 10 a.m.

The high speed, high volume trading he’s seeing can cause asset prices to gap by small increments — so that if you’re executing a trade at that minute and a high speed trader is jamming data lines at the same time, you might not get the deal at the price you thought when you pressed the button to process the trade.

What’s more, Hunsader says, this kind of trading is causing market instability—to the extent that the right set of circumstances could set off a cascade much worse than the flash crash of 2010.

“You might hear, ‘we’re doing fine, now,’” Hunsader says. “Well, yes, everything will be just fine as long as, as the news is sunshine-y happy. If you get a shock to system, you’re going to see very quickly just how undercapacity we are.”

Not everybody sees high speed trading as dangerous, of course. CNBC spoke to Jim Overdahl, a vice president at NERA Economic Consulting, who argued that high frequency trades are an important tool for professional traders.

“I think the bottom line argument on the benefits of high-frequency trading: it’s a risk management tool for professional traders,” Oberdhal said. “It allows them to quickly revise their quotes and offer better quotes because they’re able to manage the risk of being picked off by better informed trader or traders with superior information about order flow or market moving news.”

by Eamon Javers CNBC May 15, 2012

The Dangers of High-Speed Trading - US Business News - CNBC

Real Estate News

HootSuite - Social Media Dashboard